Negative potential implications: Gap (GPS23 ***), Hennes&Mauritz (HMB Stockholm **) (HNNMY 12 NR), and Inditex (ITX Madrid ***).

Europe's largest apparel retailers Hennes&Mauritz and Inditex have a solid track record in China; now the Gap (GPS23 ***) decided it wants a piece of the action.

The U.S. retailer recently announced plans to open its first store in the country in 2010. The news is seen as a positive sign for the retailer after an extended period of cost cutting, with CEO Glenn Murphy saying that the company is increasing its investments to regain market share and expand its international platform.

To understand what this move means for the Gap, it may be instructive to study the two European retailers.

China is not one of H&M's largest markets in terms of revenue generation; it has only 18 stores in the world's most populous nation. What is eye-catching about the retailer's figures from the Asian country, which it entered in 2007, is sales growth. H&M increased revenue in Germany, its largest market, by 25% in the first half of 2009; in China, revenue growth was 81%. BofA-ML thinks expansion potential at H&M is now greater than a couple of years ago, as its products have been well received in large new markets such as Japan, China, and Russia. The broker forecasts H&M could add about 10% new space per annum in the next 10 years.

Inditex, which entered the Chinese market in 2006, does not provide a breakdown of performance for individual countries. However, the world's largest apparel retailer said that Asia increased significantly its proportion of total store sales (to 12.1% in the first half of 2009 from 10.3% in the first half of 2008, by far the largest regional increase) due to Inditex's successful expansion and strong reception in the area.

Although China has been a strong growth market over the past year, one negative aspect is that manufacturers' prices (which are still falling year-over-year) are expected to turn flat and increase slightly by the end of the year. This, according to BofA-ML, is mainly due to a strengthening dollar and consolidation of supply as bigger players squeeze out smaller ones.

John Guy, retail analyst at MF Global, says Inditex and H&M are driven by western European markets and their market share in China is small. Therefore, he argues, introduction of Gap stores will have a limited effect. However, if H&M fails to continue to expand in the market, he thinks it could lose its first move advantage. Inditex, on the other hand, is more established in China, with unique products, he says.

Although Gap competes with H&M and Inditex in most of their main markets, such as the United Kingdom and France, the U.S. company has no exposure to Italy, Spain, or Germany. While entering these markets is not an imminent issue, several analysts believe that Gap might make the move eventually.

"I don't see why they wouldn't look at these markets," Guy says. However, it is important to note that these markets are very fragmented and retailers only generate low double-digit growth, he adds. Gap entering these markets would likely affect smaller retailers rather than the bigger ones such as H&M and Inditex.

With all three majors planning to expand further in the next few years, analysts are not excluding some cannibalism and views are mixed over which is the best stock to invest in. S&P Equity Research argues that H&M's defensive profile will lead to continued underperformance due to the current cyclical repositioning. S&P Equity Research has a hold recommendation on Inditex.

S&P Equity Research would not add to positions in the Gap. "Quarterly same-store sales comparisons have been negative for the past 20 quarters," writes S&P Retail Equity Analyst Marie Driscoll in the stock report. "We see traction at Old Navy with a negative 4% July-quarter comp versus negative 16% in the prior-year quarter. While we are disappointed by traffic trends across all brands, we are encouraged by improved merchandise margins and inventory management. We expect negative sales comparisons to restrict stock performance in fiscal 2010 (ending January."

Soc Gen, prefers Inditex (buy) to H&M (hold), saying H&M is harder to predict because it is slower to respond to changing sales trends. BofA-ML, meanwhile, says "of the big two international clothes retailers, we favour H&M (buy) with stronger growth potential; Inditex (underperform) looks expensive given the prospect of a sluggish recovery in earnings."

--MOHAMMED EL SADEK, S&P European MarketScope

28-Oct-2009 12:00:09 (14736581)   Copyright 2009 The McGraw-Hill Companies, Inc, Standard & Poor's, a division of The McGraw-Hill Companies, Inc., and their affiliates (collectively, "S&P"). Reproduction of this content in any form is prohibited except with the prior written permission of S&P.